The earthquake in Japan disrupted supply chains and the contemporaneous unrelated rise in oil prices curtailed consumer buying power, slowing the pace of economic growth in the first half of the year. Some think this slowdown will last for a while, which has contributed to the fairly modest decline in stock prices. We expect it to be a soft patch, nothing more. So, it remains our judgment that stock prices will end the year at higher levels.
The consequences of the disruptive effects of the earthquake were visible in every statistic related to production. GDP, industrial production, durable goods orders, all of the ISM surveys, employment, and other measures are all directly related to the level of current production. For example, when car manufacturers curtail output because they can’t get some parts, every one of the measures listed, plus others, is temporarily depressed. At its recent peak, car sales were running about 13.5 million annually, close to the pace at which cars are scrapped in the U.S. This implied there was still room for more increases in sales, production, and hiring. Instead, production was curtailed. This will prove temporary. As quickly as it can, the industry will restore production and buyers will be able to find the vehicles they want. So rather than the soft patch being sustained, we may well experience a period of faster growth in the second half, as business catches up to demand.
Similarly, the rise in oil prices took a bite out of consumer spending. When households must pay more for gasoline, they have less income available for discretionary purchases. Much of the adverse impact of this loss in spending power was offset by job growth, which provided new job holders with income to spend. Still, the rise in oil prices did hurt growth. However, oil prices have receded and gasoline prices have fallen by more than 20 cents a gallon within two weeks. Instead of higher oil prices offsetting the rise in household income from job growth, lower oil prices will now reinforce the income gains that arise from new hiring.
Investors reacted to the production disruptions and rise in oil prices by taking less risk and reducing their exposure to equities. The stock market weakened, but only ever so slightly, falling by less than 3% off its prior highs. Bonds actually rose in value. That’s not much of a retrenchment, although it felt a bit worse than that. Fears of something worse, reflecting the trauma of 2008, are surely one major factor behind this behavior. However, these market movements may be just as temporary as the factors that slowed growth in the first half of 2011.